Chapter 10 Lecture Notes

Chapter 10 Lecture Notes I. Pure Monopoly: An Introduction A. Definition: Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. B. There are a number of products where the producers have a substantial amount of monopoly power and are called near monopolies. C. There are several characteristics that distinguish pure monopoly. 1. There is a single seller so the firm and industry are synonymous. 2. There are no close substitutes for the firm s product. 3. The firm is a price maker, that is, the firm has considerable control over the price because it can control the quantity supplied. 4. Entry into the industry by other firms is blocked. 5. A monopolist may or may not engage in nonprice competition. Depending on the nature of its product, a monopolist may advertise to increase demand. D. Examples of pure monopolies and near monopolies : 1. Public utilities gas, electric, water, cable TV, and local telephone service companies are pure monopolies. 2. First Data Resources (Western Union), Wham-o (Frisbees) and the DeBeers diamond syndicate are examples of near monopolies. (See Last Word.) 3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing industries. 4. Professional sports leagues grant team monopolies to cities. 5. Monopolies may be geographic. A small town may have only one airline, bank, etc. E. Analysis of monopolies yields insights concerning monopolistic competition and oligopoly, the more common types of market situations (see Chapters 11). II. Barriers to Entry Limiting Competition A. Economies of scale constitute one major barrier. This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale (see Figure 10.9b and Figure 10.1). 1. Public utilities are often natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying existing demand. 2. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power. 3. The explanation of why more than one firm would be inefficient involves the description of the maze of pipes or wires that would result if there were competition among water companies, electric utility companies, etc. 10-1

III. B. Legal barriers to entry into a monopolistic industry also exist in the form of patents and licenses. 1. Patents grant the inventor the exclusive right to produce or license a product for twenty years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits. 2. Licenses are another form of entry barrier. Radio and TV stations, taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service. C. Ownership or control of essential resources is another barrier to entry. 1. International Nickel Co. of Canada (now called Inco) controlled about 90 percent of the world s nickel reserves, and DeBeers of South Africa controls most of the world s diamond supplies (see Last Word). 2. Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication. 3. Professional sports leagues control player contracts and leases on major city stadiums. D. Monopolists may use pricing or other strategic barriers such as selective price-cutting and advertising. 1. Dentsply, manufacturer of false teeth, controlled about 70 percent of the market. In 2005 Dentsply was found to have illegally prevented distributors from carrying competing brands. 2. Microsoft charged higher prices for its Windows operating system to computer manufacturers featuring Netscape Navigator instead of Microsoft s Internet Explorer. U.S. courts ruled this action illegal. Monopoly demand is the industry (market) demand and is therefore downward sloping. A. Our analysis of monopoly demand makes three assumptions: 1. The monopoly is secured by patents, economies of scale, or resource ownership. 2. The firm is not regulated by any unit of government. 3. The firm is a single-price monopolist; it charges the same price for all units of output. B. Price will exceed marginal revenue because the monopolist must lower the price to sell the additional unit. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output (Table 10.1 and Figure 10.2). 1. Figure 10.3 shows the relationship between demand, marginal-revenue, and total-revenue curves. 2. The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total-revenue falls. C. The monopolist is a price maker. The firm controls output and price but is not free of market forces, since the combination of output and price that can be sold depends on demand. For example, Table 10.1 shows that at $162 only 1 unit will be sold, at $152 only 2 units will be sold, etc. 10-2

D. Price elasticity also plays a role in monopoly price setting. The total revenue test shows that the monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. At this point, total revenue falls as output expands, and since total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve. (Key Question 4) IV. Output and Price Determination A. Cost data is based on hiring resources in competitive markets, so the cost data of Chapters 8 and 9 can be used in this chapter as well. The costs in Table 10.1 restate the data of Table 8.2. B. The MR = MC rule will tell the monopolist where to find its profit-maximizing output level. This can be seen in Table 10.1 and Figure 10.4. The same result can be found by comparing total revenue and total costs incurred at each level of production. (Key Question 5) C. The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on location of the demand curve. D. There are several misconceptions about monopoly prices. 1. Monopolist cannot charge the highest price it can get, because it will maximize profits where total revenue minus total cost is greatest. This depends on quantity sold as well as on price and will never be the highest price possible. 2. Total, not unit, profits is the goal of the monopolist. Table 10.1 has an example of this, in which unit profits are $32 at 4 units of output compared with $28 at the profit-maximizing output of 5 units. Once again, quantity must be considered as well as unit profit. 3. Unlike the purely competitive firm, the pure monopolist can continue to receive economic profits in the long run. Although losses can occur in a pure monopoly in the short run (P>AVC), the less-than-profitable monopolist will shutdown in the long run (P>ATC). Figure 10.5 shows a short-run loss situation for a monopoly firm. V. Evaluation of the Economic Effects of a Monopoly A. Price, output, and efficiency of resource allocation should be considered. 1. Monopolies will sell a smaller output and charge a higher price than would competitive producers selling in the same market, i.e., assuming similar costs. 2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the monopolist produces where marginal revenue and marginal cost are equal. The monopolist charges the price that consumers will pay for that output level. 3. Allocative efficiency is not achieved because price (what product is worth to consumers) is above marginal cost (opportunity cost of product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, but this will occur only under pure competitive conditions where price = marginal revenue. (See Figure 10.6) 4. Productive efficiency is not achieved because the monopolist s output is less than the output at which average total cost is minimum. 5. The efficiency (or deadweight) loss is also reflected in the sum of consumer and producer surplus equaling less than the maximum possible value. 10-3

VI. B. Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from the consumers to the business owners. This will result in a redistribution of income in favor of higher-income business owners, unless the buyers of monopoly products are wealthier than the monopoly owners. C. Cost complications may lead to other conclusions. 1. Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or, more recently, spreading product development costs over units of output, and a greater specialization of inputs. 2. X-inefficiency may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs. 3. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain government-granted monopoly privileges. Such rent-seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.), which are inefficient. D. Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others. The evidence is mixed. 1. Some monopolies have shown little interest in technological progress. 2. On the other hand, research can lead to lower unit costs, which help monopolies as much as any other type of firm. Also, research can help the monopoly maintain its barriers to entry against new firms. E. Assessment and policy options: 1. Although there are legitimate concerns of the effects of monopoly power on the economy, monopoly power is not widespread. While research and technology may strengthen monopoly power, overtime it is likely to destroy monopoly position. 2. When monopoly power is resulting in an adverse effect upon the economy, the government may choose to intervene on a case-by-case basis. Price discrimination occurs when a given product is sold at more than one price and the price differences are not based on cost differences. A. Price discrimination can take three forms: 1. Charging each customer in a single market the maximum price he or she is willing to pay. 2. Charging each customer one price for the first set of units purchased, and a lower price for subsequent units. 3. Charging one group of customers one price, and another group a different price. B. Conditions needed for successful price discrimination: 1. Monopoly power is needed with the ability to control output and price. 2. The firm must have the ability to segregate the market, to divide buyers into separate classes that have a different willingness or ability to pay for the product (usually based on differing elasticities of demand). 3. Buyers must be unable to resell the original product or service. C. Examples of price discrimination: 10-4

VIII. 1. Airlines charge high fares to executive travelers (inelastic demand) than vacation travelers (elastic demand). 2. Electric utilities frequently segment their markets by end uses, such as lighting and heating. (Lack of substitutes for lighting makes this demand inelastic). 3. Long-distance phone service has higher rates during the day, when businesses must make their calls (inelastic demand), and lower rates at night and on week-ends, when less important calls are made. 4. Movie theaters and golf courses vary their charges on the basis of time and age. 5. Discount coupons are a form of price discrimination, allowing firms to offer a discount to price-sensitive customers. 6. International trade has examples of firms selling at different prices to customers in different countries. 7. CONSIDER THIS Price Discrimination at the Ballpark D. Graphical Analysis: 1. Most price discrimination separates the market into two (sometimes more) groups of customers. This is shown in the software example depicted by Figure 10.8. 2. Because the demand curves for software for students and small businesses differ, so will their MR curves and the profit-maximizing prices and quantities for each group. 3. For each segment of the market the monopolist will set output and price according to the MR = MC rule. 4. Firms realize greater profits, and students benefit from lower prices. Small businesses face higher prices and consume less. E. Price discrimination is common, and only illegal when the firm is using it to lessen or eliminate competition. Regulated Monopoly A. This occurs where a natural monopoly or economies of scale make one firm desirable. B. As a result of changes in technology and deregulation in the local telephone and the electricity-providers industry, some states are allowing new entrants to compete in previously regulated markets. C. In those markets that are still regulated, a regulatory commission may attempt to establish the legal price for the monopolist that is equal to marginal cost at the quantity of output chosen. This is called the socially optimal price. (See Figure 10.9) D. However, setting price equal to marginal cost may cause losses, because public utilities must invest in enough fixed plant to handle peak loads. Much of this fixed plant goes unused most of the time, and a price = marginal cost would be below average total cost. Regulators often choose a price equal to average cost rather than marginal cost, so that the monopoly firm can achieve a fair return and avoid losses. (Recall that average-total cost includes an allowance for a normal or fair profit; see Figure 10.9) E. The dilemma for regulators is whether to choose a socially optimal price, where P = MC, or a fair-return price, where P = AC. P = MC is most efficient but may result in losses for the monopoly firm, and government then would have to subsidize the firm for it to survive. P = AC does not achieve allocative efficiency, but does insure a fair return (normal profit) for the firm. (Key Question 12) 10-5

VIII. LAST WORD: De Beers Diamonds: Are Monopolies Forever? A. De Beers Consolidated Mines of South Africa has been one of the world s strongest and most enduring monopolies. It produces about 45 percent of all rough-cut diamonds in the world and buys for resale many of the diamonds produced elsewhere, for a total of about 55 percent of the world s diamonds. B. Its behavior and results fit the monopoly model portrayed in Figure 10.4. It sells a limited quantity of diamonds that will yield an appropriate monopoly price. C. The appropriate price is well over production costs and has earned substantial economic profits. D. How has De Beers controlled the production of mines it doesn t own? 1. It convinces producers that single-channel monopoly marketing is in their best interests. 2. Mines that don t use De Beers may find the market flooded from De Beers stockpiles of the particular kind of diamond they produce, which causes price declines and loss of profits. 3. Finally, De Beers purchases and stockpiles diamonds produced by independents. E. Threats and problems face De Beers monopoly power. 1. New diamond discoveries have resulted in more diamonds outside their control. 2. Russia, which has been a part of De Beers monopoly, has agreed to sell progressively larger quantities directly to the world market rather than through De Beers. F. In mid-2000, De Beers abandoned its attempt to control the supply of diamonds. G. The company is transforming itself into a company that sells premium diamonds and luxury goods under the De Beers label. H. De Beers plans to reduce its stockpile of diamonds and increase the demand for diamonds through advertising. 10-6